December 2018 Newsletter Part 1: NOW We KNOW What Happened & Why?

Let's ALL Understand the Global Bear Market in Context

Dear Subscriber,

Volatility is Creating Opportunity and Testing Conviction Part 1

Well, last month we left you with the advice that until we got a solid move of panic with the VIX over 30 the correction was not over. Well dang if we did not hit 36 on the VIX on big volume for the holiday trading time. But what really happened was the bonfire of stock for sale simply ran out of fuel--for the time being.

To see the market correction in context--that is to decide if this 20%+ correction in the major US stock indexes is either:

A) Are we at the beginning of an oncoming US recession and a REAL 30%+ face ripping bear market orB) A badly needed and healthy 20% ish price correction/reset of valuations to reflect a deceleration in 2019 GDP growth to a 1.5%-2.2% GDP economy from 3%+ 2018 and a 4-5% EPS growth S&P 500 in 2019 decelerating from the 25.5% year-over-year EPS growth in 2018 (thanks to the 40% corporate tax cuts)

We need context. This deceleration in macroeconomic conditions is tricky because much of the negative growth factors are self-inflicted and come from the White House and the Fed doing things that have never been done before or doing things that in past history caused depressions.

But longtime Transformity Investor subscribers (who were with us as we stared down 2011, 2014, 2015, 2016 and early 2018 15-20% corrections) know that to arrive at the correct portfolio answer all we really need to do look at is A) the Transformity MacroMarket Economic Index B) The Mean Average of the NY/Atlanta Fed GDP Forecast for Q1 2019 andC) look at the long-term 200-week and 60-month charts of the S&P 500.

The answer? Right now what the data says is this is a market event and third 20%+ correction in this aging 10-year bull market and expansion which we still see halting in the first half of 2020 and not 2019. Why?

First a big caveat: This call includes the assumption that 1) Trump realizes he HAS TO end the trade war because he knows if he does not the stock market will tank further and 2) We do not see more that one one of our list of 20 Major Market Risks in 2019 come to fruition (You will get that list in Part II of the year-end newsletter on Monday. )

Key Point: What bears think the 20% market correction is telling us is A) the Federal Reserve made an irreparable policy tightening error (and will not taper back the $50 billion a month in capital liquidity removal—more on that issue in a moment) B) The China Trade War is not going to end in a few months and this trade war turns into a cold war which has a very significant negative impact on global economic capital and intermediate goods demand and C) Thus a US recession in 2019 starts by July 2019 and not July 2020.

I see the field of battle differently. I believe that the Fed sees the rest of the world capital markets cratering and the US stock market as the last man standing. Foreign money has flooded into the US chasing our stocks and bonds (because every other market was already in a bear market and the rising dollar turbocharges their gains when converted back to Euros or Yen). The ultra-strong dollar has become a safe haven currency that will hurt US exports badly IF tariffs are not lifted. Thus the Fed will cry uncle very soon to preserve the expansion and get dovish.

I also believe that Mr. Trump knows resolving the China Trade war before 25% tariffs kick-in is the ONLY way to keep this market event from becoming a full-blown recession anticipating 30%+ bear market. For his vanity and sociopathic need to "win" alone he will HAVE to end the war, declare “total victory” and remove the specter of a real cold war and trade tariff war with China. Otherwise, his entire sales pitch of increasing prosperity to the 60% of voters who do not approve of his “chaos and tweet” approach to running the Federal government post-recession is gone and he faces an embarrassing landslide loss in 2020.

So either way, the Fed HAS to get more dovish and turn down the $50 billion a month in auto-pilot quantitative easing and Trump has to follow his Trumpian playbook and get a few trading agreement changes (ones that were IN the TPP agreement he canceled of course) and proclaim "The largest trade deal in the history of the world."

As such dear friends, as the data stands today:

A) Our proprietary Transformity MacroMarket Economic Index of 45 economic inputs reads POSITIVE at 15.6 reading. Drop below 14 indicates an on-coming recession in 4-6 months and time for DEFENSIVE real bear market positioning to preserve bull market gains. New York Fed forecast is 2.2% Q1 2019 GDP growth in the always week first quarter, too. That may seem like a business cycle recession from 3.5% growth--and 25% EPS growth to 4-6% will feel like an "earnings" recession, but to me, that means REAL transformative growth companies with repeating/subscription revenue in s 2% ish growing economy will continue to attract new investors at now 20-50% lower valuations.

B) The 200-week SP 500 has held the 200-week support line without fail (charts courtesy of Dave Reynolds)

C) The 60-month SP 500 uptrend has held as well

﻿As of 2:15 today the S&P 500 index chart is still ugly with the dreaded "death cross" of the 50-day moving average dived down through the 200-day moving average--but without an on-coming recession the death cross tells us that the price momentum algorithm traders have taken the positive momentum OUT of the market--for now.

All this mind-boggling down/reversal/down/up and intraday moves have come of course in the pre-holiday markets that are thinly traded and very susceptible to the wild swings of algorithmic programmatic buy and sell programs programmed to launch sell and buy programs at specific relative strength bottoms and tops. And guess what--the NYSE and Nasdaq report over 80% of trades in the last 5 trading days were computer trades (the average is now 71% on a daily basis BTW). Also driving volatility in thin markets is the rebalancing of "risk-parity" investment strategies. Risk parity is a portfolio management technique that now has roughly over $500-$750 billion under mechanical management (to this add $500-$750 billion of pure price momentum CTA trading pools/hedge funds). RP has specific rules for asset allocation and trading based on financial asset volatility. In short--RP portfolios are guilty during big rises in volatility as measured by the VIX to SELL into turbulent markets and exacerbate the momentum sell-offs.

In short: the market whiplash at year end does not tell us a thing about the economy EXCEPT that its year-end portfolio positioning and the mechanics of the market for stocks that in 2018 is dominated by

$15 trillion in passive public and institutional index funds

$1.5 trillion in fast money momentum funds and risk parity strategies

Only 3600 individual stocks available to be traded on a stock exchange (used to be 8,000) which means EVERY stock is in at least one passive index

Relatively few year-end market participants which mean reduced market liquidity and did I mention year-end positioning and maybe a little WAY under-performing hedge fund pumping

Automated black box algorithmic trading machines buying and selling $100 milllion+ of stocks and ETFs in the blink of an eye based primarily on market price momentum.

So there is your answer today-- this 20%+ correction was a market event not pre-recession bear UNLESS the data changes (more on those issues in part 2)

What's next? IF we are right--and we have been right since 2009--this mean reversion to at least the 200-day moving average AFTER some 2019 tax selling in the first few days of January in which sellers dump losing positions and sell some of the biggest winners to wash taxable profits or sell winners to defer paying taxes until 2020.

Why? What really happened is the weekly composite RSI (relative strength indicator) technical gauge followed by a LOT of algos reached a level of oversold condition reached only three times during the last 10 years. Such oversold conditions have always resulted in at least a corrective bounce. What this oversold condition implies is that "selling" had at least temporarily exhausted itself. Like a raging fire, at some point the "fuel" aka stock for sale at market order is consumed and, like a forest fire, it burns itself out.

But here’s the thing: you have always heard that "for every buyer, there is a seller." While this is a true statement, it does not tell the real story.

The real issue is that while there is indeed a "buyer for every seller," the question is "at what price?"

In bull markets, prices rise until fundamental "buyers" ( those ancient folks who arrive at a present value of their forecasted profits and buy stocks they feel are undervalued based on earnings growth potential ) are unwilling to pay a higher price for there favorite securities. The disappointing missed Q2 earnings from $trillion technology ecosystem bellwethers and market leaders Apple/Micron/Nvidia/Amazon plus the global growth warnings of FEDX and negative near recession GDP reports from big exporters like Germany, Japan, Europe and <5% GDP from China plus bear markets in ALL our trading partners stock markets had fundamental stock buyers already nervous.

Then the October 3rd bombshell from Chairman Powell that the Fed was "not close to the neutral rate for Fed monetary tightening lit the fuse and the December "$50 billion of liquidity reduction is on auto-pilot" blew-up the market. The fundamental buyer's strike removed the "marginal fundamental buyer" (ie. the market bid based on fundamental valuation and macroeconomics) which lead to the highest priced and over-valued momentum stocks to fall from the lack of the marginal fundamental buyer.

Then the computer algorithmic sellers kick in (think of an algorithm as simply a recipe for when to buy or sell a stock based on a set of technical and earnings news fundamental levels and rules deduced from massive quantitative analysis of the most current factors that are present in rising and falling stocks) and automated sell programs spur selling based on failed price momentum support levels. Then passive index net buying/selling of positions kicks in around 2-2:30 aka the "institution hour" and scared retail investors started redeeming $60 billion in mutual funds and index ETFs that basically ALL OWN the same stocks based on market cap weighted indexes.

Likewise, in a recession based bear market, prices will decline until "sellers" are no longer willing to sell at a lower price and the downward momentum is halted. At the end of the day, stock movement up and down is always first a question of fundamental price/valuation and then automated and mechanized momentum and risk parity money. If value/price fundamentals and momentum algos did not matter, the market would be a flat line, right?

This highlights the importance of long-term moving averages. Again, as noted above, given that prices rise and fall due to participant demand, long-term moving averages provide the best picture of where core fundamental demand is likely to be found. When prices deviate too far above, or below, those long-term averages, prices have a history of reverting back to, or beyond, that "mean average. IF the fundamental buyers do NOT arrive to bargain hunt, the market goes down to an even more attractive valuation and the cycle starts again.

So that is where we sit coming into the new year. Currently, the market has to prove itself—and that first step has to be a mean reversion back to the 200-week (4-year) moving average. Currently, the forward 2019 P/E valuation for the S&P is 17 times the $167 EPS forecast--but take out the tech FAANG stocks and it's 15.5 and if you take out the entire technology sector (28% of the value of the S&P 500) it's closer to 13.5.

THAT is CHEAP. The long-term market average is 16.5 but with corporate tax rates now 40% lower for most companies, it makes sense to value stocks at a higher future earnings multiple (depending on their actual corporate tax rates) that the recent averages (because a dollar earned is taxed at 40% lower rate than the last 20 years--if you adjusted past earnings to this tax rate the average P/E ratio would be a lot higher).

Remember this has been a slow rolling 20% correction. First autos and homes, then banks and financials, then industrials, transports and pharma and then the small/micro caps and finally the market leading technology and healthcare sectors Utilities, consumer staples, and real estate investment trusts were last--and then they got blown up too.

In short, without an actual 2-negative GDP growth quarters in 2019 aka recession, UNLESS there is a surprise macroeconomic contagion in the United States in 2019 (which I will get too) this is still a 20% ish correction of a stock market that got drunk on a one-time-only corporate tax cut which delivered 25% EPS growth so choose your metaphor:

"Stock prices came to far too fast"

"Tech leaders were priced for perfection"

"Stocks got too far over their skis

ALL are true. But what is also true is the $trillions in cash generated from sales at >7% cash in actively managed accounts will have to go somewhere. 401-k money comes in the first quarter as well--and this time the market is 20-50% cheaper than LAST January. The algos still LOVE our transformative sector leaders that "beat top-line, beat bottom line, raise forward guidance." Value buyers are on the lookout for stock mispricings and dislocations where forced selling took securities too far below their fair 2019 value. Which brings us to

Action to Take:BUY our ultra-high income plays: After a panic liquidation they are yielding 25% or higher yields + 20% UPSIDE !!!! MIC MRRL MORL BDCL NEWT NRZ and especially MIC with 40% upside when they increase their dividend back to normal in mid-late 2019 !! The mortgage REITS and BDCs are ALL buys here on panic selling of these thinly traded securities now trading below net asset value. This was true "dislocation" -- mortgage bonds especially got panic sold into seasonally thin liquidity as if the Fed was raising short-term rates 4 times in 2019. NOW the markets only see a June hike and done! Also we expect the $20 billion of mortgage bonds sold by the Fed to slow down as well because the combined $50 billion in capital liquidity taken out of the capital markets every month or $600 billion annually (the institutional buyers are taking their liquid and buying these long duration bonds) is the equivalent of 65-80 basis points of monetary tightening according to our math.

With 25% yields and 20-40% upside, we are doubling down on these positions today for the portfolio and will continue to REINVEST these dividends in more shares as you should be doing UNTIL you actually NEED the dividends!!!

Here is the mean reversion for the S&P back to 60-month support (mean average specifically defined as the sum of the values divided by the number of values for those of you who are math challenged.)

﻿Action to take: We should expect a 12-14% move BACK to 2700 support to prove our 20%+ market event correction thesis.

We are long the 172 QQQ January 20 Call Option. HOLD for now--we will publish our new "Shopping List" on Monday with new sectors and stocks for the last inning of the Great 2009-2019 bull market.

Final Word--A very important investing principle from my new upcoming book "The Transformity Investing Principle: How To Double Your Portfolio Every 2.57 Years In Bull & Bear Markets"

A big part of why our transformative sectors and sector-leading IP do so well in bull markets is the power of positive transformational/disruptive change combined with the value-creating power of the"Reflexivity Principle" as created by George Soros the world famous $30 billion net worth hedge fund investor.

The 2018 bull market surge based on the very real 40% corporate tax cut morphed into a positive feedback loop of Reflexivity--here is what I mean by that.

Transformity Investing and Reflexivity Principle

Understanding what reflexivity is, and how it affects markets (and much more) is one of the most important fundamental truths behind the 7X outperformance of the Transformity Investing Principle.

The idea of reflexivity is centered on there being two realities; objective realities and subjective realities. Objective realities are true regardless of what participants think about them. For example, if I remark that it’s snowing outside and it is, in fact, snowing outside, then that is an objective truth. It would be snowing outside whether I said or thought otherwise — I could say it’s sunny but that would not make it sunny, it would still be snowing.

Subjective realities, on the other hand, are affected by what participants think and feel about them. Markets fall into this category. Trumpism falls into this category (but I digress). Look—since perfect information does not exist (i.e., we can’t predict the future and it’s impossible to know all the variables moving markets at any given time) we make our best judgements as to what assets (stocks, futures, options etc.) should be valued at based some formula of the present value of the foreseeable future earnings per share of a company.

Key Point: It is our collective thinking that is what moves markets and produces winners and losers. This means that what investors subjectively think about reality creates a positive feedback loop that affects objectve reality itself. And then the direct proof of an attractive objective reality, in turn, affects our thinking once again as an even more positive thus attractive reality and future reality.

Have I lost you? Stay with me, it’s not as complicated as it sounds.

First—our Transformity Investing principle and 7X market-beating results comes from the power of finding and validating true S-curve economic events + the Reflexivity Principle + our Transformity Macro Market Index (aka using oncoming business cycle transformations from expansion-to-contraction) to be long or short the US equity markets.

The Transformity Investing works incredibly well (did I mention beating the overall market by 700% or 7X) for the following reasons: Transformational commercial/regulatory/political events or change creates a massive cycle of wealth creation and wealth destruction depending on if you are a financial beneficiary or victim of the transformation change (think Netflix and Blockbuster). Rule #1: The greater the magnitude of the transformative event, the greater the magnitude of wealth creation and destruction. Rule #2: The greater the sustainability and IP security, the greater the wealth creation.

But it is only when the winners or creators of disruptive or demand building transformational change become apparent to the general investor market (and not just us and the fortunate few who understand the magnitude of transformation change/disruption that has occurred is a highly attractive and money magnetic transformational investing narrative born.

Transformational investment theses turn into investable investment themes which creates an attractive or positive investment beliefs narrative. This is when the Reflexivity principle kicks in. Early adopter money comes into the transformative event and then come fundamental theme investors arrive when the transformation blooms and starts an exponential S-growth curve. Then the momentum money/algorithmic trading floods in with the S-curve exponential growth and rising stock price momentum delivering exponential price and EPS momentum which is today purely algorithm driven

Professional and retail investors are making a ton of money and they make sure their colleagues, friends, and family know this fact—this is the so-called “dumb money” that is coming in late to the party and greedy for the “easy money” gains.

As the exponential S-curve growth cycle/wave starts to flatten—the Transformity Investing Principle says flattening exponential S-growth curves mean “this reality signals it's time to get out of these stocks/themes at the first sign of peaking because the most money comes into the theme in the last 10-20% of the cycle when flattening growth is extrapolated as exponential growth ” (the latest example of this is our sale of ALL our semiconductor and semi-equipment stocks with the peak of DRAM/NAND memory prices in late June/July and peak smartphone sales in 2018)

With these principles in mind, let’s use a highflying tech stock like Amazon (AMZN) for an example of the power of Transformity combined with the power of Reflexivity. The company has, of course, made little in the way of income (in relation to its market cap) for the majority of its public existence (over 20 years) but the stock has continued to soar after the dot-com crash in 2000. This is happening because people formed a number of positive beliefs about the stock. You can substitute Tesla here if you wish or Apple in 2006.

These beliefs could be that the company will make tons of money someday because it’s innovative, eating market share, or has a secret profit switch it can flip whenever it wants. Or maybe people continue to buy the stock because it’s gone up for a long time and so they assume it will continue to go up.

In truth, it’s probably many of these reasons that encourage investors to continue piling into a profitless company. But the reasons aren’t important. What’s important is that these positive beliefs and the transformational investment narrative have directly affected Amazon’s subjective reality.

When a company enters the transformity zone, the transformity investment narrative becomes self-reinforcing to the company’s fundamentals and thus self-reinforcing to the investment Reflexivity narrative. Here are just a few examples of how Amazon’s fundamentals have been positively affected by investors’ positive beliefs:

The high stock price has allowed the company to receive cheaper financing costs

And attract exceptional talent which in turn leads to increased growth

And hide costs by including stock options as a large portion of employee compensation

And be unconcerned with profits, enabling them to drastically undercut competition and steal market share

Key point: it’s not difficult to imagine another reality in which investors collectively had a more negative or neutral belief about the company. Amazon may look very different today. Forced to focus on profits — like many businesses — Amazon perhaps would not have had the explosive growth it’s experienced.

Maybe it never would have expanded outside of selling books. Maybe a competitor would have run it out of business. The real point is that since markets are reflexive, our mutually held beliefs about them directly affect the underlying fundamentals and vice-versa.

The most important part of Transformity Investing? Almost always in transformational change/demand driven companies, the reflexive mechanism forms a powerful positive feedback loop which causes prices and expectations to eventually drastically diverge from reality.

Here is George Soros on his Reflexivity principle:Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced.

Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback loop develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

What Soros is saying is that markets are in a constant state of divergence from reality — meaning, prices are always wrong. Sometimes this divergence is minuscule and hardly perceptible. Other times this divergence is large, due to feedback loop drivers. These are the boom and bust processes. And it is these large divergences that we as investors want to seek out because that’s where the big money is made IF we ride the wave AND jump off the peaking wave ahead of the last-in money still convinced of their subjective beliefs.

You need to learn how to identify the themes that are ripe for a strong feedback loop to form; where positive perceptions directly boost fundamentals. That is the Transformity Principle—identifying exponential growth sectors and IP leaders driving the exponential growth. These are the scenarios where a stock or sector will go parabolic.

And Soros again: Usually some error in the act of valuation is involved. The most common error is a failure to recognize that a so-called fundamental value is not really independent of the act of valuation. That was the case in the conglomerate boom, where per-share earnings growth could be manufactured by acquisitions, and also in the international lending boom where the lending activities of the banks helped improve the corporate debt ratios that banks used to guide them in their corporate lending activity.

Make reflexivity a part of your approach to understanding exponential growth companies. Not only will it allow you to better identify potentially fantastic trades, but it will also make you aware of already large price/reality divergences that are ripe for a bust when the subjective reality is replaced by objective reality.